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Economics of Contract Law

Economics of Contract Law. Agency Game I. Give me $100 and I’ll turn it into $200 and share the gain with you Do you trust me? No! Player 2 has DS to breach Solutions? Reputation in a repeated game Contract law. Agency Game II.

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Economics of Contract Law

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  1. Economics of Contract Law

  2. Agency Game I • Give me $100 and I’ll turn it into $200 and share the gain with you • Do you trust me? • No! Player 2 has DS to breach • Solutions? • Reputation in a repeated game • Contract law

  3. Agency Game II • Suppose we sign a contract in which I am punished if I run off with the money • Court forces me to pay you $150 and charges each of us an additional $25 fee for doing so 1st Purpose of Contract Law is to enable people to cooperate Requires a way to make a promise credible (some sort of commitment)

  4. Example 1 The rich uncle of a struggling college student learns at the graduation party that his nephew graduated with honors. Swept away by good feeling, the uncle promises the nephew a trip around the world. Later the uncle reneges on his promise. The student sues his uncle, asking the court to compel the uncle to pay for a trip around the world.

  5. Example 2 One neighbor offers to sell a used car to another for $1000. The buyer gives the money to the seller, and the seller gives the car keys to the buyer. To her great surprise, the buyer discovers that the keys fit the rusting Chevrolet in the back yard, not the shiny Cadillac in the driveway. The seller is equally surprised to learn that the buyer expected the Cadillac. The buyer asks the court to order the seller to turn over the Cadillac.

  6. Grasshopper Terminator Example 3 A farmer, in response to a magazine ad for “a sure means to kill grasshoppers,” mails $25 and receives in the mail two wooden blocks with the instructions, “Place grasshopper on Block A and smash with Block B.” The buyer asks the court to require the seller to return the $25 and to pay $500 in punitive damages.

  7. Bargain Theory of Contracts I • A promise should be enforced if it was given in a bargain, otherwise it should not. • Offer • Acceptance • Consideration • Rich uncle: no consideration offered • Disputed car: no “meeting of the minds” • Grasshopper killer: enforceable bargain Promisor: person who gives a promise Promisee: person who receives it “reciprocal inducement” How do you enforce a gift promise?

  8. Bargain Theory of Contracts II • What should the remedy be for broken promises? • Expectations damages: amount promisee could reasonably expect from performance • Problems with the Bargain Theory • Requires all promises to have consideration • Car shopping and a “firm offer” • Requires that all bargains be enforced • Grasshopper killer? Economic efficiency requires enforcing a promise that both parties want enforced.

  9. Economic Theory of Contract • Rich uncle: both want the promise enforced • Disputed car: no cooperative surplus • Grasshopper killer: enforce the promise to discourage deceit by promisor 1st Purpose of Contract Law is to enable people to cooperate

  10. 2nd Purpose of Contract Law is to encourage efficient disclosure of information • Used car market • You value my car 50% more than I do • Asymmetric information exists • No mechanics [0---------------------------5000] $2500 (your guess as to value of car to me) Suppose you offer $3000 [0-------------------3000] You will end up paying $3000 for a car that’s only worth $2250 to you $1500 (your revised guess as to value of car to me)

  11. 3rd Purpose of Contract Law is to secure optimal commitment to performing. • What should be the remedy for efficient breach? • Painting sale • You value my unfinished painting at $1000 • We agree on a sale price of $600 upfront • Crazy cousin makes $5000 offer • It’s efficient for me to breach contract with you: • Cost of performance > benefit you will get from the painting • Airplane sale • You value my plane at $500,000 • We agree on a sale price of $350,000 • Before construction begins, price of metal rises and raises my cost to $1,000,000

  12. 3rd Purpose of Contract Law is to secure optimal commitment to performing. • Optimal Performance • If promisor’s cost of performing > promisee’s benefit from performing, then breach is efficient • If promisor’s cost of performing < promisee’s benefit from performing, then performance is efficient • Choice of remedy is critical • If penalty for breach is too severe, the promisor will have to perform, even though breach may be efficient • If penalty for breach is too weak, the promisor will breach when efficiency requires performance

  13. 3rd Purpose of Contract Law is to secure optimal commitment to performing. • Actual Performance Decision: • If promisor’s cost of performing > promisor’s liability for breaching, then he will breach • If promisor’s cost of performing < promisor’s liability for breaching, then he will perform • Perfect Expectations Damages • Promisor’s liability = promisee’s benefit from performance • Restores promisee to position he would have enjoyed if promise had been kept

  14. Painting Sale I • You value my unfinished painting at $1000 • We agree on a sale price of $600 upfront • Crazy cousin makes $5000 offer • What are Expectation Damages? • DE = $1000 • What if D = $6000 4600, 400 -400, 5400 Painter breaches and it is efficient Painter performs though breach is efficient

  15. Painting Sale II • You value my unfinished painting at $1000 • We agree on a sale price of $600 upfront • Crazy cousin makes $5000 offer • Assume simple DE • Buyer purchases frame for $50 which raises value of painting to $1200 Whether painter performs or not, reliance makes you better off But, is reliance efficient?

  16. 4th Purpose of Contract Law is to secure optimal reliance. If Expected Gain from Reliance > Cost of Reliance then Reliance is efficient p = probability of performance ∆V = increase in value of performance due to reliance c = cost of reliance If p(∆V) > C then reliance is efficient Painter ex: ∆V = 200 c = 50 When the probability of performance is high, more reliance tends to be efficient  p* = 0.25

  17. 4th Purpose of Contract Law is to secure optimal reliance. • Warning: if my damages cover your benefit whether or not it’s efficient, then you’ll always spend on reliance (over-reliance) • Solution: Perfection Expectations Damages • damages needed to restore the promisee had the promise been kept, and had he relied the optimal amount • Foreseeability Doctrine • “Reasonably expected” reliance

  18. Hadley v Baxendale (1854) • Hadley ran a mill and crankshaft broke • Baxendale was to deliver it to engineers • Delayed one week (used boat rather than rail) • Hadley sued for week’s worth of lost profits • Court ruled lost profits were not foreseeable

  19. 5th Purpose of Contract Law is to minimize transaction costs of negotiating contracts by supplying efficient default rules • Gaps: contract is silent about risks • Inadvertent gaps: not foreseeable • Deliberate gaps: remote risks • Default rules • Compute hypothetical bargain • Who can bear risk at lowest cost? • Adjust price of the contract Cost of allocating a risk > Expected cost of allocating a loss  leave gap Cost of allocating a risk < Expected cost of allocating a loss  fill gap

  20. McGuire v Wabash • McGuires hire Wabash to build new house • Price of copper rises by $2000 and contract is silent • McGuires refuse to pay extra $2000 • Suppose Wabash knows that copper costs could rise by $2000 with p = 0.50 • Expected cost = (0.50)(2000) = $1000 • Suppose Wabash could’ve hedged risk for $400 • Hypothetical bargain • Who is the low cost bearer of risk? • If risk was foreseeable, Wabash would charge extra $700 • McGuires pays $700 • Wabash absorbs $1300 loss Wabash

  21. Perfect Contracts and Market Failures • Perfect Contract • All risks is efficiently allocated • All relevant information is communicated • All resources allocated to those who value it the most • Individual Irrationality • Incompetence • Dire constraints • Necessity • Duress • Transactions Costs • Spillovers • Asymmetric information • Monopoly Exceptions to perfect contracts

  22. 6th Purpose of Contract Law is to foster enduring relationships, which solve the problem of cooperation with less reliance on the courts to enforce contracts • Coffee shop and the forgotten wallet • Prisoner’s Dilemma • One-shot game: DS is to cheat • Repeated game: Cooperative outcome is Pareto Optimal • Endgame Problem “tit-for-tat” strategy “Rarely will buyers leave saying they bought the wrong goods at too high a price. Our goal is to make them eager to come back. We offer a source which provides a competitive edge, all of which translates directly into increased profits.” NY Diamond Dealer’s Club

  23. Peevyhouse v Garland Coal (1962) • Peevyhouse owned farm in Oklahoma • Garland contracted to strip-mine coal • Contract specified that Garland would take steps to restore land to previous condition • Garland breached • Peevyhouse sued for $25,000 • Restorative costs were estimated to be $29,000 at trial • Garland showed that “diminished value” of farm was only $300 • Original jury awarded $5000 to Peevyhouse • OK Supreme Court reduced damages to $300 • Efficient breach? • Dissent: specific performance was warranted, otherwise no formation would have occurred

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